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An Introduction to Managed Futures January 2004 | Man Investments

Managed futures funds have experienced a steady influx of capital over the last decade, increasing from around USD 5 billion at the end of the 1980's to over USD 50 billion by the end of 2002.

Money under management in managed futures 1980 - 2002

Source: Barclay Trading Group, Ltd.

Much of this growth can be credited to greater investor awareness of the valuable benefits managed futures can add to investment portfolios, including the potential to generate healthy profits in rising or falling markets. Indeed, over the last 5 years, managed futures have produced a total return of 48.1%2 against a drop of -20.6% for MSCI World Stocks.3

To gain an insight into managed futures it is instructive to take a look into what they are, where they have come from and what advantages they can offer to an investor.

Overview

Also known as Commodity Trading Advisors (CTAs), managed futures are a pool of futures or forwards contracts managed by professional money managers. They are similar to a mutual fund, in that individual or institutional investors have a share, only the investments in this case are mainly futures contracts. Unlike fundamental securities such as stocks and bonds which are held within a mutual fund, a future is a derivative instrument, one whose value depends on the value of an underlying instrument.

Futures contracts originated to help reduce risk for farmers by ensuring a guaranteed price for their crops. The price of a commodity was established on the day of contracting and a small deposit placed by the purchaser to ensure delivery. The actual delivery occurred on a future date, and the outstanding payment was settled. This allowed farmers to establish future prices for commodities such as wheat and helped merchants establish costs in advance of a purchase.

Organised futures markets began with the opening of the Chicago Board of Trade (CBOT) in 1848 as American Midwest farmers trading with east coast merchants needed to bring order and standardization to the chaotic conditions that existed in their industry.

During the 1970's, the exchanges began to develop a number of financial futures for hedging interest rate and currency risk. The number of financial instruments for hedging, or speculating, has grown exponentially since 1980.

Today, managed futures provide direct exposure to international financial and non-financial asset sectors. Trading advisors have the ability to trade in over 100 different markets worldwide. These markets include interest rates, stock indexes, currencies, precious metals, energies and agricultural products.

Features of managed futures

For a trade to occur there must be a buyer and a seller. The buyer is said to be long and the seller short. Futures markets provide unique opportunities to generate profits in many market environments because it is just as easy to sell short contracts as it is to buy them. In traditional markets it is often difficult, or even impossible, to sell assets not already owned, necessitating a more traditional buy and hold approach that is dependent on bull markets to return profits.

This also allows traders to easily bring their net position in a particular futures contract back to zero so that no delivery of goods is necessary. This is done through an offset trade where the original transaction is reversed exactly.

Also, the purchase of a futures contract does not involve payment of the entire value of the transaction. Only a fraction of the value is deposited, known as a margin payment. Margin is a good faith deposit that indicates the trader's willingness and ability to fulfil all financial obligations that may arise from trading futures. One effect of the marginal deposit requirement is that a proportion of remaining funds can be allocated to other markets.

Because the margin deposit needed to buy or sell a futures contract is only a portion of the current market value of the contract, managed futures have an inherent degree of leverage. Any change in the price of a security can consequently result in a much larger percentage gain or loss on the funds deposited as margin. A proficient use of leverage can result in desired levels of return for the amount of capital employed.

Types of managed futures

Typically managed futures use a systematic approach to investment, although some use discretionary trading methods. Discretionary trading relies on the judgement of the manager and their expertise within a particular market to make investment decisions.

The more prevalent systematic approach relies on the application of technical analysis to evaluate the movements of markets, such as changes in price and volume.

The trading is based on the systematic application of quantitative models that use moving averages, break-outs of price ranges, or other technical rules to generate buy and sell signals for a set of markets. This tends to be automated, particularly with the emergence of electronic trading systems

In general, most managed futures managers tend to view price trends as a function of supply and demand for a particular commodity or financial instrument. As the interaction of these elements form continuous market movements they try to capture profits. In short, managed futures managers attempt to identify the beginning of a trend, take a position and exit it as it ends.

Protective stops can be adjusted daily and more positions might be built up if the trends are stable, or quickly reduced during adverse or highly volatile periods. Also the amount of risk on groups of related markets and on the total portfolio can be controlled. Further risk reduction is achieved by means of market diversification.

Managed futures investments can benefit from the application of a range of trading systems or investment strategies, such as systematic, arbitrage, and spread trading strategies. Investment approaches can also be differentiated by trading frequency and duration.

Managed futures within a portfolio

The developments over the last twenty years have made managed futures a specialised but increasingly significant asset class within the investment industry. Importantly, high quality managed futures funds are capable of achieving attractive returns with risks comparable to those of a traditional stock investment. Furthermore, managed futures can enhance the diversification of a portfolio and therefore play an important role in improving the risk and reward characteristics of that portfolio.

Potential impact of adding managed futures to a traditional portfolio
1 January 1985 to 28 February 2003

Because managed futures provide an opportunity to profit from both upward and downward directional moves in the underlying assets and cover a wide range of commodity and now financial contracts, it is possible to achieve a low level of correlation with traditional forms of investment. This means that the performance of managed futures need not be tied directly to the price movements of the underlying assets being traded. Optimal diversification can be achieved when there is no, or only low, correlation between the constituent elements of a traditional investment portfolio. The more independent of market performance the returns of a futures fund are, the more the fund is suited for inclusion in a traditional portfolio.

Exposure across the full range of market sectors helps to smooth out peaks and troughs in performance due to the tendency of markets in each sector to display broadly different behavioural characteristics. For example, the factors affecting world commodity markets frequently differ from those influencing traditional asset classes. Like capital markets, global commodity markets tend to move in cycles - with periods of price strength usually associated with growth and stability in the world economy and periods of weakness with recession - but within these broad cycles there are often seasonal and sharp price movements prompted by a sudden change in the supply picture as a result of environmental or political factors. Trading commodities using futures, it is possible to reap gains from the sometimes fervent upward and downward price movements that result from the uncertainty that frequently drives these markets.

Futures funds themselves can be structured with a high level of diversification. The significant growth in the number and diversity of futures markets in recent years has facilitated a broadly diversified approach across geographical regions and asset classes, avoiding over-concentration in any market or market sector.

Summary

Historically, managed futures have shown low or negative correlations to stock and bond market returns, and this low correlation is expected to continue. Some of the factors that have a negative impact on the stock markets, such as economic and political uncertainty, can cause moves in the prices of currencies or energy to create profit opportunities that managed futures managers exploit.

Access to numerous global investment opportunities means managed futures can offer an important diversification opportunity, and their addition to an investment portfolio can help smooth overall returns. Any investor considering an allocation to managed futures should approach them first and foremost as a long term investment. A commitment of capital to managed futures should be based on the track record, reputation and length of experience of the manager.

Source: Barclay Trading Group, Ltd and Standard & Poor's Micropal. There is no guarantee of trading performance and past performance is not necessarily a guide to future results.
World stocks: MSCI World Stock Index (Total Return)

This promotion is communicated by Man Investments Ltd which is authorised and regulated by the Financial Services Authority. Potential investors should note that alternative investments can involve significant risks and the value of an investment may go down as well as up. There is no guarantee of trading performance and past performance is not necessarily a guide to future results. This material is only to be communicated to persons outside the UK and should not be relied upon by any other person.

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